Lecture 5 Flashcards
(37 cards)
Mechanisms improving corporate governance quality:
Law enforcement
Product market competition
Internal governance
Capital marekts (shareholders, creditors and market for corporate control)
Whistleblowers, mdedia, short seller activism and academics
internal auditors
Provide assurance on the internal control process, risk management and governance
Detect violations
Reduce agency costs within an organization
External auditors
Appointed by shareholders
Provide assurance on the quality of financial and non financial reports of a company
Reduce information asymmetry between management and investors
Improve trust and transpacency
External auditors play a crucial role in the well function of financial markets
Who are the external auditors
Former big five:
Arthur anderson (fall out after enron)
Pricewaterhousecoopers
Deloitte
Ernst & young
KMPG
What are the advantages of auditors in detecting fraudulent behaviors
Independent, imparcial and professional
Standardized approach to validate companys financial reports
Fresh look at the companys operation than insiders
What are the disadvantages in digging fraudulent behaviors
Difficult to obtain sensitive data
Hard to comprehend the complexity of an organization with time pressure
Challenging audit quality
Audit independence
Are paid by their audit clients
Advice their audit clients on tax, strategy and M&As
Invest in audit clients, beneficiary of the clients financial well being
Work later for the firms for career advances
External auditors could effectively spot fraudulent behaviors in a company:
How to solve this: regulation:
Mandatory audit rotation, but can be hacked as well
Higher auditing standards for increased costs of audit by 5-20%
External auditors could effectively spot fraudulent behaviors in a company:
How to solve this: shareholders vot on auditor ratification during general annual meeting
In recent years, more and more shareholders vota gainst managements choice of auditors
Credit rating agencies (similar incentives like auditors)
Paid by the issuing company (of corporate bond)
Provide rating on the financial solvency of the company
Heavily regulated since the financial crisis in 2008
Governance rating agencies
Paid by investors
Provide rating on the corporate governance quality
ESG rating agencies
Paid by investors
Providing rating on the ESG impacts firm profitability (single materiality)
Many players in an unregulated field
Key users of ESG ratings
Institutional investors base their investment on ESG ratings
Firm level decision making, CEO compensations liked to ESG ratings
Academics use ESG ratings for empirical studies
ESG ratings increasingly influence financial decisions, with potentially far-reaching effects on asset pricing and corporate policies
ESG investing: rationale of asset managers
Growing investor demand
Reduce risk of fines
Avoid costs from reprecussions of investees externalities
Immprove ability to benefit from sustainability megatrends
Higher fees for ESG funds (5 times the normal funds…)
Key providers of ESG ratings
Sustainalytics
Moodys ESG
S&P global
Refinitiv
MSCI
Bloomberg LP
trucost
CDP etc.etc.
Single materiality
How environmental and social changes may materially affect firms profitability
Double materiality
It is not just climate related impacts on the company that can be material but also impacts of a company on the climate and society - or any other dimension of sustainability, for that matter
msci’s ESG rating
No universal standard
Compared to industry peers, default rating BBB, above average, lower than average
Arbitrary weights assigned on E,S,G issue
Single materiality, only about ESG impacts on firms profit
MSCI ESG indicies are widely used but rarely understood
Heavy polluters still included in the MSCI sustainability index
ESG rating an aggregate confusion –Berg et al (2022) WP
Challenges
Low correlation (0.38-0.71) across ESG ratings
Difficult to evaluate ESG performance of firms, funds and portfolios
Lead to under investment in real ESG activities that matter
Hard to ocnduct meaningful research on ESG
DIvert attention and efforts from really fighting climate change
ESG rating an aggregate confusion – Berg et al (2022) WP
Sources of difference
Measurement (56% of the divergence)
Scope (38% of the difference)
Weight (6%)
Rely too much on self reported data by assessed company
Lack of universal standard
Challenges with regulations
Lagging behind, mostly triggered by big scandals or crisis
Lacking holistic perspective, singular measures that twist incentives
Political swings
Subject to obby and bribery by interest groups
Highly costly, compliance and enforcement costs
Regulatory arbitrage by firms
Reduce the willingness of managers to take risks
unregulated markets are feeding grouds for frauds
Importance of regulation: Laws and regulations are the cornerstone of financial markets
Fiducary duty + business judgement (of managers)
Legal limitations on takeover defenses
Information disclosure
Investor protection
Countries with better law and enforcement tend to have better functioning financial markets and therefore higher economic competitiveness
Shleifer et al (2000) key messages:
Civil law is associated with
Greater government invervention in economic activities
Weaker investor protection compared to common law
Implications of civil law:
Ownership structure
Firms in countries with weaker investor protection may need more concentrated control
